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What’s a Good PE Ratio: How Do Price-To-Earnings Ratios Work?

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Recently, semiconductor giant Nvidia hit new all-time highs thanks to its concerted efforts towards establishing a niche in artificial intelligence. This seems to have also ushered in a bull run as the Nasdaq is up almost 30% year-to-date. While bullish investors and traders welcome this rally with open arms, critics are calling this the calm before the storm as they bring up the concern of valuations. During times of euphoria and emotion-driven stock rallies, it's important to fall back on key financial metrics so investors and traders are aware of the fundamentals that the stocks are growing upon.

One such metric is the price-to-earnings (PE) ratio, which provides insights into a company's valuation relative to its earnings. For many investors and traders, understanding the significance of a good PE ratio is crucial for identifying potentially lucrative opportunities.  In this article, we will delve into the world of PE ratios, examine both high and low PE ratio stocks and highlight the factors that influence them.

What is PE Ratio

Also known as the price multiple or earnings multiple, the PE ratio is calculated by dividing the current market price of a stock by its earnings per share (EPS). It serves as a valuation metric, reflecting how much investors are willing to pay for each dollar that a company earns.

When it comes to basic valuation assessment metrics, the PE ratio is the go-to metric for analysts to quickly gauge if a security is undervalued or overvalued based on how much the company is earning as per its annual net profits. In a nutshell, the PE ratio offers insights into investors' expectations and sentiments regarding a company's prospects. For many old-school investors, the PE ratio is an essential valuation metric for comparing different stocks within the same industry or across sectors. By analysing high and low PE ratio stocks, investors can gain valuable insights into the market's perception of a company's growth potential and overall performance.

PE Ratio Formula & Calculation

The PE ratio of a company is calculated by dividing the current market price of a stock by its earnings per share (EPS). To calculate a company's PE ratio, make use of the following PE ratio formula: PE Ratio = Market Price per Share / EPS

Let's take Apple Inc.'s current market price and EPS as an example using its most recent quarterly data.

Apple Inc. (AAPL) Share Price = $177.30

EPS = 1.52 + 1.88 + 1.29 + 1.2 = 5.89

PE Ratio = Market Price per Share / EPS

= 177.30 / 5.89

= 30.10

Now that we have AAPL's trailing-twelve-month (TTM) PE ratio of 30.10, we know that this figure implies Apple is currently trading at a premium of 30 times its weighted average earnings. With that understood, let's now take a look at variations to the PE ratios we're used to.

PE Ratio Variations

Forward PE Ratios

Forward price-to-earnings ratio (FPE) is an evaluation tool used to measure the value of a company’s stock in relation to its current earnings. It is calculated by dividing the current stock price by the company's forecasted earnings over the next 12 months. In essence, FPE ratios, like other price-to-earnings ratios, look at the potential rate of return on investment that an investor can expect when buying a particular stock. However, unlike other PE ratios, FPE ratios do not consider the company's past performance or its historical levels of profitability. This makes the FPE ratio particularly useful for making short-term investments and evaluating stocks with high growth potential.

PEG Ratios

Like PE ratios, the Price/Earnings-to-Growth (PEG) ratio is a way for investors to assess the value of stocks through the lens of a company’s earnings growth rate. It takes into account the company's expected earnings growth rate in addition to its PE ratio. By using both the PE ratio and the expected growth rate, PEG provides a more accurate representation of a stock's current valuation relative to its future performance. It offers a better look at whether a company's stock is undervalued or overvalued when compared to its sector peers. However, it should be noted that PEG ratios aren't always reliable since the accuracy of this metric depends heavily on how accurately analysts can predict the company's future growth rates

What is a Good PE Ratio?

Now that we have discussed how to calculate the PE ratio, it's essential to understand what constitutes a good or bad PE ratio. A good PE ratio should be lower than its industry peers and the overall market average. As such, investors should compare different stocks within the same sector or across other sectors to gauge whether the PE ratio is low enough to constitute a potential buying opportunity. In this instance, we should look at similar big tech companies like Alphabet (NASDAQ: GOOGL) and Microsoft (NASDAQ: MSFT). With GOOGL's PE ratio of 27.92 and MSFT's PE ratio of 35.90, we can see that AAPL shares can be considered a decent buy compared to MSFT. On the other hand, Apple may seem overvalued when pitted against Alphabet.

All in all, while deciding whether something is a buy or sell goes beyond PE ratios, it's a handy metric to keep in mind when determining whether a stock is undervalued or overvalued when compared to its peers. With this covered, our next seciton will look into what investors and traders should account for when looking at high and low PE ratio stocks.

Interpreting Stocks With High PE Ratios: Good or Bad?

Although some investors might immediately decry stocks with high PE ratios as 'bad' and 'overvalued', that isn't always the case. Here's what investors and traders need to take away when researching companies with high PE ratios:

Growth Expectations

A high PE ratio typically suggests that investors are optimistic about a company's future growth prospects. It indicates that the market anticipates higher earnings growth and is willing to pay a premium for the stock. High PE ratio stocks are often associated with companies operating in fast-growing industries or those with innovative products and services. Examples include Tesla (NASDAQ: TSLA) and Nvidia (NASDAQ: NVDA), both of which are hugely popular stocks that tout the potential to revolutionise the world with their technology. From self-driving robotaxis to a world run by artificial intelligence, these stocks possess astronomical growth expectations. As such, this is reflected in their high PE ratios and market capitalisation.

Market Sentiment

Market sentiment plays a crucial role in determining a stock's PE ratio. During periods of optimism, investors may be willing to pay higher multiples for stocks, leading to elevated PE ratios. However, it is essential to consider the underlying fundamentals and industry trends to assess if the high PE ratio is justified. An example would be during the 2020 bull market when plenty of tech stocks possessed sky-high PE ratios as investors and traders bought in because of the bullish market sentiment. At its peak, the S&P 500 reached a PE ratio of 39.9, an amount that was last seen in the early 2000s during the dot com bubble.

Industry Comparison

Comparing a company's PE ratio to its industry peers is vital in understanding whether a high PE ratio is reasonable. Industries with high growth potential, such as technology or biotech, often command higher PE ratios. Conversely, mature and stable industries may have lower PE ratios due to their more predictable earnings. An obvious comparison would be the likes of Tesla against defensive stocks like Coca-Cola (NYSE: KO).

Evaluating Stocks With Low PE Ratios: Is It Always Good?

Undervalued: that's the word that will immediately come to mind when discussing the long-term prospect of low PE ratio stocks. Here's everything you need to consider when researching low PE ratio stocks and discovering if they're truly undervalued gems.

Low for a Reason?

While a low PE ratio may present attractive investment prospects, it can also indicate possible underlying weakness. Due to a lack of growth in a company, its earnings could stagnate, signifying that it's at risk of failing to exist in the near future. In such instances, it is vital to assess why a company has a low PE ratio and ensure that such reasoning is sound before taking any further actions. Examples of such weakness can range from being in a sunset industry and the company's inability to grow further to failing financial health that requires a scaleback in operations.

The Essence of Value Investing

A low PE ratio may indicate that a stock is undervalued or out of favour with investors. However, value investors will often seek out such stocks with low PE ratios and consider them potential bargains. A recent example would be the GameStop (NYSE: GME) short-selling saga, which started because one investor felt that the stock was heavily undervalued because of its low PE ratios and bought in with a significant position.

The Bottom Line

In conclusion, it is crucial for investors and traders to understand the nuances of PE ratios and their implications for stock valuation. In general, high PE ratio stocks often indicate optimism about a company's growth potential. In contrast, low PE ratio stocks can present opportunities for value investors. By understanding this, investors and traders can quickly perform a surface-level analysis of a company and understand the relative value of its shares to its peers. On top of this, investors can also conduct comprehensive research and compare ratios to make the most informed decision when assessing their buying and selling decisions.

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